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Chapter 11
Audit of Acquisition Cycle and Inventory
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Overview of Acquisition CycleThe acquisition cycle covers the purchase, receipt,
payment, and accounting for goods and servicesMajor accounts include inventory, accounts
payable, and expensesMain phases in the acquisition and payment
process: Authorized requisition Authorized purchase Receipt of goods and services Approval for payment Cash disbursement
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Discuss Risk and Business AnalysisAcquisition cycle deals with receipt of all goods and services
Misstatements may occur just because of the volume of transactions
It is also an area where fraud is likely to take place. For example, Employee theft of inventory causing inventory on the books to be
overstated Employees setting up fictitious vendors and paying themselves
for goods never received by the company Executives abusing travel and entertainment expenses for
personal use Capitalizing expenses as assets to inflate earnings Overestimating "restructuring reserves" at the time of acquisition
so expenses could be reduced in future periods
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What are the red flags of the acquisition and payment cycle?There are a number of red flags unique to the acquisition
and payment cycle. These include: Inventory growing at a rate greater than sales Expenses significantly above or below industry norms Capital assets growing faster than the business and for
which there are not strategic plans Significant reduction of "reserves" Expense accounts that have significant credit entries Travel and entertainment expense accounts that do not
have documentation Inadequate follow-up to auditor recommendations on
needed controls
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What analytical analysis can be done for misstatements?
Analytical procedures to identify potential misstatements: Calculate and analyze dollar and percentage change in
inventory, cost of goods sold, and expense accounts Compute and analyze ratios like inventory turnover and
number of day's sales in inventory Prepare common sized income statement to identify cost
of good sold or expense accounts that are out of lineAuditor compares client analytics to past client
performance, industry results, and auditor's expectations
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Overview of Control Procedures and Control Risk Assessment
Requisition goods or services Need identified Pre-numbered requisition form completed and sent to purchasingPurchase goods or services Purchase order shows quantity and price of goods ordered, quality
specifications, shipping terms Purchase orders are pre-numbered to establish completeness Purchase orders must be properly authorized Many companies have separate purchasing department:
Agents job is to find best combination of price, service, and quality Reduces fraud by separating purchasing from custody and recording Centralizes control in one location Controls set to stop purchasing agents from abusing their positions
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Overview of Control Procedures and Control Risk AssessmentReceive goods Receiving department should ensure
Only authorized goods are received The goods meet order specifications An accurate count of goods received is taken All receipts of goods are recorded
Receiving reports are pre-numbered to establish completeness
Receiving department records quantity of goods received
Goods also inspected for quality Receiving reports sent to accounting
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Overview of Control Procedures and Control Risk AssessmentApprove payment Accounting matches vendor invoice, purchase
order, and receiving reports - If quality and quantity match, account payable is recorded
Cash disbursement Supporting documentation is reviewed and
approved for payment Documents are marked "paid" to avoid duplicate
payment
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Testing Controls over Accounts Payable and Related ExpensesThe primary risk is that Accounts Payable and expenses
will be understatedTherefore, controls related to the following are usually
significant: Proper authorization Completeness of recording Timeliness of recording Correctness of valuationAttribute sampling (Chapter 9) may be used to test control
operationThe level of assessed control risk will impact the rigor of
the subsequent substantive testing of Accounts Payable and expenses
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What are some substantive tests of accounts payable? The auditor's main concern is that Accounts
Payable will be understatedTherefore, emphasis is placed on testing the
completeness assertionTypical substantive tests include:1. Reconcile vendor statements or confirm
accounts payable2. Tests of subsequent disbursements3. Analytical review of related accounts
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1. Reconciling Vendor Statements or Confirm Accounts Payable
Auditor requests vendors' monthly statements or sends confirmation to major vendors
Auditor reconciles vendor statement or confirmation with client balance in the accounts payable subsidiary ledger
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2. Testing Subsequent Disbursements Auditor samples cash disbursements after
the end of the year Determines if disbursements are for audit
year transactions by vouching back to source documents (purchase order, vendor invoice, receiving report)
If disbursement is for audit year transaction, auditor reprocesses the transaction to see if it was properly recorded as a payable
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3. Analytical Review of Related Expense Accounts Used to determine if accounting data
indicates understatement of expenses
If understatement likely, auditor expands tests of accounts payable
Analytics used on clients with low control risk
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Auditing of Expense AccountsAuditing payables and cash disbursements provides
indirect evidence about expense accountsAdditional analysis of selected expense accounts is usually
meritedThe auditor should consider management is more likely to Understate rather than overstate expenses Classify expenses as assets rather than vice versa
Substantive audit procedures include: Detailed tests of transactions Analytical review Review of unusual entries
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Auditing of Inventory & Cost of Goods SoldAudit of inventory is complicated by a number of factors
including: Variety (diversity) of items High volume of activity Various (sometimes complex) valuation Difficulty in identifying obsolete or defective inventory Many frauds involve the inventory account Easily transportable making it subject to double counting May be stored at multiple locations, some may be
remote May be returned by customers
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What are some internal controls for inventory?A well-designed inventory control system should ensure: All purchases are authorized Accounting system ensures timely, accurate, and
complete recording Receipt of inventory properly accounted for Inventory tested for quality when received/manufactured Costs properly identified and assigned to products Customer returns of inventory examined for defects Inventory reviewed for obsolescence New products introduced only after market studies and
quality control tests have been made Management actively manages inventory Long term contracts are closely monitored
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Substantive Tests of Inventory & Cost of Goods Sold Existence: observe year-end physical
inventory Completeness: cutoff tests Rights: review long-term contracts,
etc. Valuation: direct tests and analytics Disclosure: review GAAP
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Procedures for Observing a Client's Physical Inventory - Existence
Meet with client to discuss their plan to count inventory Review client's plans for counting and tagging inventory Review inventory counting procedures with audit
personnel Determine whether specialists are needed to identify
inventory items Upon arriving at each site:
Meet with client, and obtain map and schedule of inventory count area
Obtain list of sequential tag numbers for each area Observe procedures to shut down receipt or shipment of goods;
obtain document numbers for last receipt and shipment for cutoff tests
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Observe the counting of inventory and note the following:
The first and last tag numbers in each section Account for all tag numbers to prevent later
insertion of additional inventory items Make selected test counts Items that appear obsolete or defective High-dollar value items in inventory Movement of inventory during counting process
Document conclusion as to quality of the inventory counting process
Procedures for Observing a Client's Physical Inventory - Existence
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What does the auditor do after the inventory count? - Existence
After the inventory count, the auditor should: Trace the test counts to the client's
inventory records Trace the number of high-dollar items to
the client's inventory records Trace the obsolete or damaged inventory
to the client's inventory records to see if the items have been written down
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Counting Inventory Before or After Year-end - ExistenceOn occasion, it may not be feasible to count inventory at
year-endAcceptable to count inventory before or after year-end if: Controls are strong The opportunity and motivation to misstate inventory is
low Auditor can test the year-end balance using analytics
and tests of transactions between the physical count and year-end (called the roll-forward or rollback period)
Auditor reviews intervening transactions for unusual activity
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Cut Off - Completeness Inventory cutoff tests: Obtain information on last items shipped and received at
year-end Compare this information to transactions recorded in the
sales and purchases journal Determine if transaction is recorded in correct
accounting period
Auditor should also inquire about any inventory out on consignment or stored in a public warehouse
Tracing test counts and number of high-dollar items to the client's inventory records tests completeness (as well as existence)
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Comment on Allowance for Returns - Valuation In most situations, expected returns of
inventory are not material However, some companies provide return
guarantees and expect significant returns Management can use previous
experience, updated for current economic conditions, to develop estimates of returns
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Rights
Most of the work regarding ownership of inventory is performed during the auditor's testing of purchases
Auditor should also review long-term contracts to determine obligations
Inquiry should be made about inventory on consignment
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Inventory Valuation - ValuationMost complex assertion related to inventory because of the: Volume of transactions Diversity of products Variety of costing methods Difficulty in estimating net realizable value of productsAuditor uses direct tests and analytics to assess inventory valuation: Direct tests include verifying cost by reviewing vendor invoices Auditor usually examines current market data and other conditions
that might indicate inventory obsolescence Management inquiry and review of industry publications can help
the auditor identify obsolete units Analytics, like inventory turnover or day's sales in inventory, may
identify slow-moving inventory which may need to be written down Auditor looks for obsolete units during the counting of inventory;
these units may need to be written down
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DisclosureAuditor reviews client disclosure for
compliance with GAAP
Disclosure should include: Costing method(s) used Frequency of accounting Inventory pledged as collateral Any other unusual circumstance
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Cost of Goods Sold Audit of cost of goods sold can be direct
tied to the audit of inventory If beginning and ending inventories have
been verified and acquisitions have been tested, cost of goods sold can be direct calculated
Auditor should also apply analytics to cost of goods sold to see if there are any significant variations - either overall or by product line